The Price of Immediacy

Authors

  • GEORGE C. CHACKO,

  • JAKUB W. JUREK,

  • ERIK STAFFORD

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    • Chacko is with 6S Capital AG, Santa Clara University, and Trinsum Group Inc.; Jurek is with Harvard University and Harvard Business School, and Stafford is with Harvard Business School. This paper has previously been circulated under the title, “Pricing Liquidity: The Quantity Structure of Immediacy Prices.” We thank John Campbell, Joshua Coval, Will Goetzmann, Robin Greenwood, Bob Merton, André Perold, David Scharfstein, Anna Scherbina, Halla Yang, and seminar participants at Harvard Business School, INSEAD, MIT, The Bank of Italy, and State Street Bank. We are especially grateful to an anonymous referee whose comments substantially improved the paper.


ABSTRACT

This paper models transaction costs as the rents that a monopolistic market maker extracts from impatient investors who trade via limit orders. We show that limit orders are American options. The limit prices inducing immediate execution of the order are functionally equivalent to bid and ask prices and can be solved for various transaction sizes to characterize the market maker's entire supply curve. We find considerable empirical support for the model's predictions in the cross-section of NYSE firms. The model produces unbiased, out-of-sample forecasts of abnormal returns for firms added to the S&P 500 index.

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